XCHRX LIEM TJONG SIUN and Others v. LAW CHI HUNG and Another

1996 No. A516

IN THE SUPREME COURT OF HONG KONG

HIGH COURT

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J U D G M E N T

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INTRODUCTION

1. On 8th March 1996, the Defendants filed a summons under Ord. 14A seeking the determination of an issue of construction. The summons came before Mr. Registrar Betts on 25th November 1996. He determined the issue of construction in favour of the Plaintiffs. He must have been told that the determination of that issue of construction in favour of the Plaintiffs meant that there was no other issue in the action, because he proceeded to enter judgment for the Plaintiffs for the sum claimed in the action. The Defendants now appeal against those orders.

THE FACTS

2. The primary facts are not in dispute. I take them from the 2nd affirmation of the 3rd Plaintiff. The Defendants were partners in a partnership which traded under the name A. & L. Trading Co. In the summer of 1995, the partnership had an urgent cash flow problem. Accordingly, the Defendants asked the Plaintiffs for an injection of capital. The sum they sought was $450,000.00. They claimed that the partnership had good business connections with customers who regularly placed orders with it, and that its profitability was promising. They proposed that a limited company should be incorporated, that the Plaintiffs should provide finance to the company, and that the company should then acquire the business and assets of the partnership.

3. What were the Defendants to do in return for this finance? As the 3rd Plaintiff put it in her affirmation, the Defendants "guaranteed that the ... company would make such profits toward the end of 1995 that the Plaintiffs would be able to share a 100% return on [their] cash investment". In the context, that must have meant that the Defendants were warranting that the Plaintiffs' share of the profits of the company by the end of 1995 would not be less than $450,000.00. In addition, they promised the Plaintiffs that if the Plaintiffs' share of the profits did not reach that target, they would repay the Plaintiffs their investment of $450,000.00, and pay them in addition a further sum of $450,000.00 representing "the guaranteed profits".

4. The Plaintiffs agreed to these proposals. A limited company, Regal Rich Industrial Ltd. ("Regal Rich"), was acquired, and shares in it were allotted to the Plaintiffs and the Defendants. The Plaintiffs were allotted 70% of the issued shares and the Defendants 30%. In addition, an agreement was drawn up and signed by the Plaintiffs and the Defendants. That agreement was called the "shareholders' agreement", and it was dated 7th September 1995. The relevant clause is cl. 9. In cl. 9.1, the Defendants "jointly and severally guarantee[d]" to the Plaintiffs that they would procure the partnership to sell all its fixed assets, and to assign its interest in various contracts, to Regal Rich for the sum of $450,000.00 which was to be paid by Regal Rich to the partnership. In cl. 9.2, the Defendants "jointly and severally guarantee[d] with [the Plaintiffs] that if the total profit to be shared by [the Plaintiffs] as at 31st December 1995 [would] be less than $450,000.00, then they [would] reimburse [the Plaintiffs the sum] of $900,000.00 at 31st December 1995".

5. The Plaintiffs duly caused the sum of $450,000.00 to be paid to the Defendants. However, they claim that their share of the profits of Regal Rich was less than $450,000.00 by 31st December 1995. Accordingly, they issued proceedings claiming the sum of $900,000.00 under cl. 9.2, and that was the sum for which they obtained judgment.

THE ISSUE OF CONSTRUCTION

6. The issue of construction which the Defendants wanted to have determined on the summons under Ord. 14A was whether cl. 9.2 of the shareholders' agreement amounted, on its proper construction, to a penalty, and whether it was for that reason unenforceable. Mr. Registrar Betts decided that it was not a penalty.

7. The law on the topic is clear:

"Where the parties to a contract agree that, in the event of a breach, the contract-breaker shall pay to the other a specified sum of money, the sum fixed may be classified by the courts either as a penalty (which is irrecoverable) or as liquidated damages (which are recoverable). The clause is enforceable if it does not exceed a genuine attempt to estimate in advance the loss which the plaintiff would be likely to suffer from a breach of the obligation in question: it is enforceable irrespective of the loss actually suffered": Chitty on Contracts, Vol. 1, 27th ed., para. 26-061.

The words "in the event of a breach" are important. That is because the House of Lords in Export Credit Guarantee Department v. Universal Oil Products Co. [1983] 1 W.L.R. 399 held that the law of penalties does not apply to a sum which is due upon the occurrence of an event other than a breach of the defendant's contractual duty owed to the plaintiff. In the light of that, Mr. Jason Pow for the Plaintiffs submits (as he submitted to Mr. Registrar Betts) that the law of penalties is not engaged in this case because the Defendants' liability under cl. 9.2 of the shareholders' agreement to pay the sum of $900,000.00 did not arise as a result of any breach of the Defendants' contractual obligations to the Plaintiffs. It was triggered by the occurrence of another event, namely the fact that the Plaintiffs' share of the profits of Regal Rich was less than $450,000.00 as at 31st December 1995. Mr. Registrar Betts accepted that argument. That is not surprising. The Defendants represented themselves at the hearing before him, and Mr. Pow's beguiling argument was not challenged.

8. However, Mr. E. M. Packwood has represented the Defendants on this appeal. He has argued that the law of penalties has been engaged in this case. He contends that in cl. 9.2 the Defendants were warranting that the Plaintiffs' share of the profits of Regal Rich would not be less than $450,000.00 by 31st December 1995. If the profits did not reach that target, the Defendants would be in beach of that warranty. Their liability to pay the sum of $900,000.00 arose, it is said, as a result of their contractual failure to deliver what they had promised, namely the guaranteed level of profitability.

9. In essence, therefore, the issue is: what did the Defendants promise to do? Was their contractual promise limited, as the Plaintiffs contend, to agreeing to pay the Plaintiffs the sum of $900,000.00 if the forecast level of profitability was not achieved? Or did their contractual promise relate, as the Defendants contend, to the level of profitability itself, i.e. did they warrant that the profitability of Regal Rich would reach the forecast level? In my view, the language of cl. 9.2 is more consistent with the Plaintiffs' construction, but I have no doubt that the language is such that the Defendants' construction cannot be excluded. It is, I think, possible to read cl. 9.2 as providing:

"[The Defendants] hereby jointly and severally guarantee with [the Plaintiffs] that ... the total profit to be shared by [the Plaintiffs] as at 31st December 1995 [will not] be less than $450,000.00, [but if it is] they [will] reimburse [the Plaintiffs the sum] of $900,000.00 at 31st December 1995."

In order to resolve the ambiguity inherent in the language of cl. 9.2, I am entitled to look at the surrounding circumstances, including what was said in the pre-contractual negotiations.

10. It is here that it becomes apparent that the Defendants' construction of cl 9.2 is to be preferred. I repeat what I said earlier. Having regard to the language used by the 3rd Plaintiff in her 2nd affirmation, the Defendants warranted in the pre-contractual negotiations that the Plaintiffs' share of the profits would not be less than $450,000.00 by the end of the year. I think that that amounted to a guarantee about the level of the Plaintiffs' share of the profits. But even if it did not, it was at the very least a warranty that the forecast was sound and reliable in the sense which Lord Denning M.R. had in mind in Esso Petroleum Co. Ltd. v. Mardon [1976] Q.B. 801 at p.818B, i.e. that the Defendants, who alone had knowledge of the business, made the warranty with reasonable care and skill.

11. Accordingly, the sum of $900,000.00 was payable in the event of the Defendants being in breach of that warranty. I appreciate that pre-contractual negotiations can be an unreliable guide as to what an ambiguous term in the subsequent agreement means. After all, parties may change their bargaining positions in those negotiations. But the 3rd Plaintiff expressly said in her 2nd affirmation that the Plaintiffs entered the shareholders' agreement "on the basis" of what was discussed in the pre-contractual negotiations. Since cl. 9.2 could therefore only have been included in the shareholders' agreement in order to give effect to the Defendants' pre-contractual warranty, the sum of $900,000.00 was payable by the Defendants to the Plaintiffs under cl. 9.2 in the event of the Defendants being in breach of that warranty - which the Defendants would be if the Plaintiffs' share of the profits was less than $450,000.00 by 31st December 1995. Accordingly, I hold that the law of penalties has been engaged in this case.

12. In reaching this conclusion, I have not overlooked the irony which the Defendants' case discloses. In order to bring their obligations under cl. 9.2 within the law of penalties, they have to assert that they were subject to a contractual obligation - namely, a warranty relating to the profitability of Regal Rich - which the Plaintiffs expressly disavow. However, despite that irony, I remain of the view that the Defendants did indeed warrant the profitability of Regal Rich, with the consequence that the question whether their obligation to pay $900,000.00 under cl. 9.2 constitutes a penalty still arises.

PRE-ESTIMATE OF LOSS

13. Against that background, I turn to whether the sum of $900,000.00 represented a genuine attempt to estimate in advance the loss which the Plaintiffs would be likely to suffer if their share of the profits of Regal Rich was less than $450,000.00 by 31st December 1995. I have no doubt that it did not. It was payable irrespective of the amount by which the Plaintiffs' share of the profits fell short of $450,000.00. And it was payable even though the Plaintiffs would continue to have a 70% shareholding in Regal Rich, and even though Regal Rich would continue to own the business and assets of A & L. Trading Co. I appreciate that if the business of Regal Rich completely failed, the Plaintiffs would have lost their investment of $450,000.00, and would not have made the guaranteed profit of $450,000.00 either. But that was the greatest loss which the Plaintiffs would have suffered, and cl. 9.2 took no account whatever of any other possibility, including the other extreme of Regal Rich failing only by a whisker to make the guaranteed level of profits. I therefore rule that the Defendants' obligation to pay to the Plaintiffs the sum of $900,000.00 was a penalty, and is unenforceable for that reason.

EFFECT OF CL. 9.2 BEING A PENALTY

14. However, that is not the end of the matter. If the Plaintiffs' share of the profits of Regal Rich was less than $450,000.00 by 31st December 1995, the Plaintiffs are still entitled to damages for the Defendants' breach of warranty that their share would not be less than that, even though those damages cannot be treated as amounting to $900,000.00 under cl. 9.2. It is for that reason that the action could not have been dismissed - which was what the Defendants had sought in their summons in the event of the issue of construction being decided in their favour. The question now is whether the Plaintiffs are entitled to judgment for damages to be assessed. The answer is maybe, but not now. The Defendants do not admit that the Plaintiffs' share of the profits of Regal Rich was less than $450,000.00 by 31st December 1995. Whether that was so has still to be determined, whether on an Ord. 14 summons for summary judgment or otherwise. In addition, the Defendants may, for all I know, have other defences to the Plaintiffs' claim. For those reasons, it would not, I think, have been appropriate for Mr. Registrar Betts to have given the Plaintiffs judgment on their claim, even though he had decided the issue of construction in favour of the Plaintiffs.

CONCLUSION

15. Accordingly, for the reasons I have endeavoured to give, this appeal must be allowed, and the order of 25th November 1996 must be set aside. I declare that by cl. 9.2 of the shareholders' agreement dated 7th September 1995 between the Plaintiffs and the Defendants, the Defendants warranted to the Plaintiffs that the Plaintiffs' share of the profits of Regal Rich would not be less than $450,000.00 by 31st December 1995. I also declare that, to the extent that cl. 9.2 required the Defendants to pay the sum of $900,000.00 to the Plaintiffs in the event that the Plaintiffs' share of the profits of Regal Rich was less than $450,000.00 by 31st December 1995, cl. 9.2 amounted to a penalty, and is therefore unenforceable against the Defendants. None of this, of course, implies any criticism of Mr. Registrar Betts. As I have said, he must have been told that the determination of the issue of construction in favour of the Plaintiffs meant that there was no other issue in the action, and the argument which has persuaded me that the law of penalties has been engaged in this case was not deployed before him at all.

16. I shall hear the parties on costs, and on any directions I should give for the further conduct of the action.